A Tricky Year-End for IRA Owners




Update Dec. 19: On Dec. 11 Congress passed legislation that suspended the required minimum distribution requirement for 2009. But it did not change the requirement for 2008. the IRS was asked by members of Congress to suspend the requirement for 2008. But on Dec. 17 it sent a letter to key members of Congress saying it would not do so. An IRS official told the Washington Post that it did not have authority to change the rules. Only Congress could do that. In addition, the IRS could not devise a solution that would be fair to those who took their 2008 RMDs before December.

The financial crisis continues to have secondary effects few people anticipated. Decisions are required now, especially with regard to IRAs. Let's take a look at the key issues in question-and-answer format.

Is there relief for IRA owners over age 70½ who have not yet taken their required minimum distributions for the year?

IRA owners must take required minimum distributions by April 1 off the year after they turn age 70½ and by Dec. 31 of each year after they turn age 70½. The RMD is computed based on the IRA balance as of Dec. 31 of the preceding year. The Dec. 31, 2007, balance is used to determine the 2008 RMD. We discussed details of computing the RMD in the April 2008 visit, and that discussion is available on the web site Archive.

The problem for 2008 is that many IRA balances are far below their 2007 levels. Major stock market indexes are down around 35% to 40% from that date. Some investments declined even more. IRA owners who have not already taken their RMDs for the year are required to take RMDs on wealth that no longer exists.

There is only one limited provision in the tax law to reduce the RMD in this circumstance. The RMD is fulfilled when the amount taken from the IRA brings the balance to zero. That does not help many IRA owners. If taking the RMD does not wipe out all your IRAs, you are required to take the full RMD as calculated using the 2007 balance.

Several proposals were put forth in Congress in 2008 to provide some way of altering the requirement for those whose IRAs declined. None was enacted, but there is a possibility of some action in a special session now taking place. If there is a bailout bill for the auto companies there is a chance a waiver for RMDs will be included. But that is not very helpful, since you have to take your distribution by Dec. 31, and IRA sponsors often get backed up this time of year. If you wait to put your RMD order in, it might not be processed by Dec. 31. IRA owners are in a tough spot on this issue, because waiting to see if Congress acts could mean a distribution won’t be made by the Dec. 31 deadline if Congress does not act.

Can the RMD be avoided by converting the traditional IRA to a Roth IRA?

The original owner of a Roth IRA does not have to take RMDs (though beneficiaries who inherit Roth IRAs do). A traditional IRA can be converted to a Roth IRA when the owner's adjusted gross income is no more than $100,000. There are taxes due on the conversion. The converted amount must be included in gross income as though it were distributed. The converted amount and any RMD for the year do not count in determining the $100,000 limit.

This is a good time to convert a traditional IRA to a Roth IRA, because asset values have declined. You can make the conversion at a much lower cost than a year ago, and the future income and gains will be distributed tax free to you and the IRA beneficiary.

A conversion, however, cannot be used to avoid a current required minimum distribution. If the IRA owner is required to take an RMD for the year, the RMD still must be taken even if there is a conversion and regardless of the date during the year the conversion occurred. The conversion, however, will avoid future RMDs.

If I have to take an RMD this year, which assets should I sell to take it?

A common misconception about RMDs is that an asset has to be sold and then the cash distributed from the IRA. In fact, a distribution of either cash or property meets the requirement, as long as the value of the property on the day of the distribution equals the RMD for the year. Or if several distributions are taken over the year to fulfill the RMD, the aggregate of the property values on the dates of their distributions must at least equal the RMD. You don’t have to sell any assets to take an RMD.

Most IRA custodians also offer taxable accounts. It is a simple procedure to set up a taxable account at the custodian. Then, direct the custodian to transfer property from the IRA at least equal in value to the RMD to the taxable account. The transferred property can be bonds, shares of stock or mutual funds, other securities, or any other property in the IRA. The custodian will determine if some of the property is not transferable.

If the custodian does not offer taxable accounts, set up a taxable account at another financial institution that will accept the assets. Then, have the securities or other assets transferred from the IRA to the new taxable account. This transfer might take more time, so the paperwork has to be started earlier in order to meet the Dec. 31 requirement.

If you do not want to sell assets to fulfill the RMD, you do not have to. Instead, distribute property from the IRA to a taxable account. The value of the property at the time of the distribution will be included in gross income and count as the RMD. The tax basis of the assets will be their value on the date of distribution, the same amount included in gross income. Because of the tax treatment, it makes sense to distribute those assets that have declined the most and are likely to appreciate the most in the future. Once those assets are in a taxable account, future appreciation is likely to be taxed as long-term capital gains. If the assets remained in the IRA, future appreciation would be taxed as ordinary income when distributed. Also, if the assets continue to decline in value after being distributed, the assets can be sold and the loss deducted on the tax return. Losses in an IRA cannot be deducted in most cases.

I need at least part of the RMD in cash to pay expenses. How should I determine which assets to sell and distribute? Those that have declined the most, the least, or some other measure?

One step investors fail to take on a regular basis is to rebalance their portfolios. A portfolio should have a target asset allocation that meets your return goals and risk tolerance. Over time the markets move the portfolio out of balance because the investments will have different rates of return. The portfolio should be rebalanced to bring it back to its original allocation target.

RMDs can be used to rebalance the portfolio. Sell or take distributions of assets in ratios that bring the portfolio to its target allocation. Sell assets that are above or closest to their targets. That is the fastest way to bring the portfolio back to target. Other changes can be made within the IRA to bring it back to your target allocation, such as selling those that have declined the least to buy more of those that are farthest from their targets. You can choose to make sales and distributions in other ways, but recognize that those would be a change in your portfolio strategy.

Another approach is to use tactical asset allocation to choose the RMD assets. For example, you might choose to hold the assets that have held their value best. Or you might hold those that have declined the most, believing they are likely to appreciate the most when things turn around. Either move would be a bet on coming market trends. The first strategy would be an assumption that recent trends will continue. The second move would be based on a belief that we are near a bottom and you want to capture the following rally. There is nothing wrong with either move. Be aware that you would be straying from your initial strategy and effectively making a forecast about the market.

I sold an asset in my IRA to take a distribution. Can I buy that same asset in my taxable account?

This question is a reference to the "wash sale" rules which prevent a taxpayer from selling an asset to deduct a loss but immediately buying the same asset so that the portfolio position has not changed. The wash sale rules say that a loss deduction is deferred if a substantially identical asset is purchased within 30 days before or after the sale. The wash sale rules apply whether the substantially identical asset is purchased in an IRA or taxable account.

Since a loss incurred in an IRA is not deductible, however, the wash sale rules do not discourage or prohibit you from purchasing a substantially identical asset in a taxable account after selling it in an IRA.

What are the rules for making charitable donations directly from an IRA?

For most people, there is no good reason to make a charitable contribution from an IRA. If you do, the amount is treated as a distribution and included in gross income. You can take a charitable contribution deduction for the identical amount. But you must itemize deductions on Schedule A to benefit. In addition, if your income is high enough, the itemized deduction reduction reduces the amount of your charitable contribution. So, you might not have a full offset of the amount included in gross income.

Those who are over age 70½ receive special treatment. This provision was in effect for 2007 only but recently was extended to the end of 2009.

The special treatment is that a charitable contribution can be made directly from the IRA without including it in gross income. There is no offsetting deduction, but there is no gross income either. Only the first $100,000 of charitable contributions from IRAs each year receives this treatment. In addition, the contribution must be made directly from the IRA to the charity. You must direct the IRA custodian to make the transfer or issue a check.

Another bonus is that the donation can count as part of your RMD for the year. You still are required to take the full amount of the RMD based on the 2007 balance. But by giving all or part of the RMD to charity, the amount does not have to be included in gross income.

Posted 12-05-2008 9:15 AM by Bob Carlson
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